Tax Free Organisations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations
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Tax-Free Reorganizations: Acquisitive Reorganizations

Resource type: Practice Note Status: Maintained Jurisdiction: USA
This Note provides an overview of tax-free acquisitive reorganizations. Acquisitive reorganizations are transactions where one corporation acquires the stock or assets of another corporation. PLC Corporate & Securities
Contents
General Categories of Tax-Free Reorganizations Acquisitive Reorganizations Divisive Reorganizations Restructuring Reorganizations Bankruptcy Reorganizations General Requirements to Qualify as a Tax-Free Reorganization Judicial Requirements for All Tax-Free Reorganizations Direct Type A Reorganization Tax Consequences of a Direct Type A Reorganization Direct Type A Reorganization with a Disregarded Entity Direct Type B Reorganization Tax Consequences of a Direct Type B Reorganization Direct Type C Reorganization Tax Consequences of a Direct Type C Reorganization Acquisitive D Reorganization Tax Consequences of an Acquisitive Type D Reorganization Triangular Reorganizations Type A Forward Subsidiary Merger Type A Reverse Subsidiary Merger Triangular Type B Reorganization Triangular Type C Reorganization Carryover of NOLs after a Tax-Free Reorganization Limitations of the Use of NOLs After a Tax-Free Reorganization Double Dummy Merger: Tax-Free Transaction but not Tax-Free Reorganization
Certain types of corporate acquisitions, divisions and other restructurings can be structured to
http://uscorporate.practicallaw.com/0-386-4212
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qualify as tax-free reorganizations for US federal income tax purposes. If the requirements of a taxfree reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock and asset transfers. Tax is deferred rather than eliminated, because the basis (www.practicallaw.com/5-382-3262) of the stock or assets received in a tax-free reorganization is a carryover basis (www.practicallaw.com/2-382-3310). The receipt of a carryover basis in a tax-free reorganization preserves the unrecognized gain for later recognition in a taxable sale or other disposition. This Note focuses on acquisitive tax-free reorganizations. Acquisitive reorganizations are transactions where one corporation acquires the stock or assets of another corporation. Unless otherwise indicated, this Note addresses only US federal income tax considerations of taxfree reorganizations and assumes that the: Acquiring corporation (or parent and subsidiary, as applicable) and target corporation are US corporations that are C-corporations (www.practicallaw.com/1-383-9868). Target corporation has only US stockholders. Acquiring corporation and target corporation are not related parties. A tax-free reorganization may have state law tax consequences so it is important to consult with a state law tax specialist when structuring an acquisition. For a discussion of tax-free reorganizations in public merger transactions, including links to recent deals summarized in PLC What's Market, see Practice Note, What's Market: Tax-free Transactions (www.practicallaw.com/5-386-1032). For more information about taxable transactions, see Practice Notes, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235), Stock Acquisitions: Tax Overview (www.practicallaw.com/9-383-6719) and Mergers: Tax Overview (www.practicallaw.com/0-383-6747).
General Categories of Tax-Free Reorganizations

Tax-free reorganizations can be divided into four basic categories: Acquisitive reorganizations. Divisive reorganizations. Corporate restructuring reorganizations. Bankruptcy reorganizations.
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Acquisitive Reorganizations
Acquisitive reorganizations are transactions where one corporation acquires the stock or assets of another corporation. Included in this category are the following types of reorganizations: A reorganization. A merger or consolidation that is effected under state or foreign statutes. In a typical A reorganization, the target corporation's assets and liabilities become assets and liabilities of the acquiring corporation and the target corporation ceases to exist (see IRC (www.practicallaw.com/2-382-3555) 368(a)(1)(A)). B reorganization. An acquisition of stock of the target corporation in exchange solely for voting stock of the acquiring corporation, provided that the acquiring corporation has "control" (generally 80% ownership) of the target corporation immediately after the transaction (see IRC 368(a)(1)(B)). C reorganization. An acquisition of "substantially all" the assets of the target corporation in exchange for voting stock of the acquiring corporation (and a limited amount of consideration other than qualifying stock, also known as boot) followed by a liquidation of the target (see IRC 368(a)(1)(C)). Acquisitive D reorganization. The transfer of "substantially all" of the target corporation's assets to an acquiring corporation, provided that the target corporation or its stockholders (or a combination of the two) has "control" (generally 80% ownership) of the acquiring corporation immediately after the transfer. The target corporation also must liquidate and distribute to its stockholders the acquiring corporation stock and any other consideration received by the target corporation from the acquiring corporation (as well as the target's other properties (if any)) in a transaction that qualifies under IRC 354 (see IRC 368(a)(1)(D)). Triangular reorganizations. Types A, B and C acquisitive reorganizations can often also be structured as triangular tax-free reorganizations. Unlike a direct reorganization which involves two parties (the target corporation and the acquiring corporation), a triangular reorganization generally involves three parties: the target corporation on the seller side and a parent corporation and a subsidiary on the buyer side.
Divisive Reorganizations
Divisive reorganizations are transactions where one corporation divides into two or more corporations and that qualify as a divisive Type D reorganization under IRC 368(a)(1)(D). Divisive reorganizations take three different forms: Spin-offs. A transfer of the assets of the parent corporation (typically the assets of a division or line of business) to a newly formed corporation and dividend of the stock of the newly formed
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corporation to the parent corporation's stockholders. Split-offs. An exchange offer in which the stockholders of the parent corporation exchange their stock in the parent for stock in a new entity. Split-ups. A transfer of the assets of the parent corporation to two or more newly formed corporations and dividend of the stock of the newly formed corporations to the parent corporation's stockholders. The parent corporation liquidates and the stockholders hold shares in the two or more newly formed companies.
Restructuring Reorganizations
Restructuring reorganizations are adjustments to the corporate structure of an existing (and continuing) corporation. Included in this category are the following types of reorganizations: E reorganization. A recapitalization under IRC 368(a)(1)(E)). A recapitalization is a reshuffling of an existing corporation's capital structure. For example, a corporation's issuance of common stock for outstanding preferred stock (or an issuance of preferred stock for outstanding common stock) generally qualifies as a recapitalization (see Treas. Reg. (www.practicallaw.com/0-382-3882) 1.368-2(e)). F reorganization. A mere change in identity, form or place of organization of a corporation under IRC 368(a)(1)(F). For example, changes in the state or jurisdiction of incorporation generally qualify as Type F reorganizations. In addition, if a corporation converts from one type of organization to another, it may qualify as a Type F reorganization (see Rev. Rul. 67-376).
Bankruptcy Reorganizations
Bankruptcy reorganizations are transactions that involve the transfer of assets from one corporation to another corporation in a bankruptcy or similar case and that qualify as Type G reorganizations under IRC 368(a)(1)(G).
General Requirements to Qualify as a Tax-Free Reorganization

To qualify as a tax-free reorganization, a transaction must meet the statutory requirements for one of the types of tax-free reorganizations (for example, the direct Type B reorganization requirements) which are discussed in detail below (see IRC 368 and the accompanying Treasury Regulations). In addition, a tax-free reorganization generally must also satisfy the three judicial requirements (continuity of interest, continuity of business enterprise and business purpose) that apply to all tax-free reorganizations. The type of consideration generally determines whether a transaction can qualify, in whole or in
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part, as a tax-free reorganization. Stock of the acquiring corporation (or its affiliate) generally must be used as a significant portion of the consideration and, in certain tax-free reorganizations, the stock must be voting stock. If a selling stockholder receives boot (meaning, consideration other than qualifying stock), the stockholder generally is taxed on the receipt of the boot.
Judicial Requirements for All Tax-Free Reorganizations

In addition to the specific statutory requirements for each of the different types of tax-free reorganizations (which are discussed in detail below), a tax-free reorganization generally must also satisfy three judicial requirements: continuity of interest (COI), continuity of business enterprise (COBE) and business purpose. Continuity of Interest The COI requirement generally requires that the historic stockholders of the target corporation receive a substantial equity interest in the acquiring corporation (or its affiliate). This requirement prevents transactions that resemble sales from qualifying as tax-free reorganizations. It is satisfied by using stock of the acquiring corporation (or its affiliate) as a significant portion of the consideration (varying from about 40% to 100% of the consideration, depending on the type of reorganization). Stock of any class (common or preferred and voting or non-voting) generally counts towards the COI requirement. Debt, cash and cash equivalents do not count towards the COI requirement. Many of the different types of reorganizations have built-in statutory COI requirements. For example, the only permissible consideration in a B reorganization is voting stock. Continuity of Business Enterprise After the transaction, the acquiring corporation must continue at least one of the target's significant historic businesses or use a significant portion of the target's historic business assets in a business. Business Purpose A bona fide business reason (other than tax savings) is required for the transaction.
Direct Type A Reorganization

A direct Type A reorganization is a merger or consolidation under state or foreign law that satisfies the COI, COBE and business purposes requirements (see IRC 368(a)(1)). Unlike many other taxfree reorganizations, a direct Type A reorganization does not have any statutory restrictions on the type of stock that can be used as consideration (common or preferred and voting or non-voting are all permissible) and only requires that 40% of the consideration consist of the acquiring corporation's stock (this is the COI requirement, see Temp. Treas. Reg. 1.386-1T(e)(2)(v), ex. 1). A direct Type A reorganization that fails to meet the necessary requirements generally is taxed as an asset acquisition (see Practice Notes, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235) and Mergers: Tax Overview (www.practicallaw.com/0-383-6747)). A typical direct Type A merger is structured as a forward merger. In a forward merger, the target corporation merges into the acquiring corporation. For corporate purposes, the target corporation's
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assets and liabilities become assets and liabilities of the acquiring corporation and the target ceases to exist. A typical direct Type A merger is shown in the diagrams below:
In a typical Type A consolidation, two corporations are combined into a new corporate entity. For corporate purposes, the old corporations' assets and liabilities become assets and liabilities of the new corporate entity and the old corporations cease to exist. A typical Type A consolidation is shown in the diagrams below:
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If some stockholders receive all cash (for example, dissenters) and others receive stock (or a mix of stock and cash), the transaction can still qualify as a direct Type A reorganization. However, only the target corporation stockholders who receive stock are entitled to tax-free treatment. After a direct Type A reorganization, the acquiring corporation can generally transfer the acquired assets to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing taxfree reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively, if a drop down is planned, the transaction can be structured as a triangular Type A reorganization (see Type A Forward Subsidiary Merger and Type A Reverse Subsidiary Merger). However, the requirements for the triangular Type A reorganizations are more onerous than a direct Type A reorganization.
Tax Consequences of a Direct Type A Reorganization

If the requirements of a direct Type A reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock and asset transfers. Target Corporation Stockholders The target corporation stockholders do not recognize taxable gain or loss on the exchange of their target stock for acquiring stock (see IRC 354). However, the target corporation stockholders that
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receive boot are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock (generally redeemable preferred stock which does not participate in corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to a target corporation stockholder. The target corporation stockholder takes a carryover basis in the acquiring corporation stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target Corporation The target corporation generally does not recognize gain or loss in the tax-free reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist. Acquiring Corporation The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a carryover basis in the target corporation's assets (generally the same basis that target corporation had in the assets) (see IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Direct Type A Reorganization with a Disregarded Entity

In certain cases, a state law merger involving a disregarded entity can qualify as a direct Type A reorganization. A disregarded entity is an entity with a single owner that is generally ignored for tax purposes even though it is a separate legal entity for state law purposes. For example, a singlemember limited liability company (www.practicallaw.com/6-382-3582) (LLC) is treated as a disregarded entity for tax purposes unless it elects to be taxed as a corporation. The single owner of the disregarded entity is considered to own the assets (and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. For more information about disregarded entities, see Practice Note, Choice of Entity: Tax Issues (www.practicallaw.com/1-382-9949). The merger of a target corporation into an acquiring corporation's disregarded entity may qualify as a direct Type A reorganization if the COI, COBE and business purpose requirements are satisfied. However, the merger of a target corporation's disregarded entity into an acquiring corporation generally does not qualify as a direct Type A reorganization (see Treas. Reg. 1.368-2(b)(1)(iii), ex. 2). The acquiring corporation may prefer a merger of the target corporation into the acquiring corporation's disregarded entity if the acquiring corporation wants to shield itself from the target's liabilities.
Direct Type B Reorganization

In a direct type B reorganization, the acquiring corporation acquires the stock of target corporation solely in exchange for voting stock of the acquiring corporation and, immediately after the
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transaction, the acquiring corporation has "control" of the target corporation (see IRC 368(a)(1) (B)). Control means at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock (see IRC 368 (c)). The COI requirement is built into the statute for a Type B reorganization (voting stock is the only permissible consideration) but the transaction must also meet the COBE and business purposes requirements. A Type B reorganization that fails to meet the necessary requirements is taxed as a stock acquisition (see Practice Note, Stock Acquisitions: Tax Overview (www.practicallaw.com/9-383-6719)). A direct Type B reorganization is shown in the diagrams below:
After a direct Type B reorganization, the target corporation is 80% or more owned by the acquiring corporation. Because the target corporation continues to exist, stockholders that opted not to participate in the reorganization may continue to own target corporation stock as minority stockholders if that is permitted under state law. The only permissible consideration in a Type B reorganization is voting stock. In many instances, voting preferred stock can be used if the holder has the right to vote on the election of directors (see Rev. Rul. 63-234). However, the use of any other consideration (even a single penny)
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generally disqualifies the transaction. However, the "solely in exchange for voting stock" requirement will not be violated if: Target corporation stockholders receive cash in lieu of fractional shares. Acquiring corporation pays target corporation's transaction expenses (legal, accounting and so on). Target corporation redeems shares of stockholders that opted not to participate in the reorganization using its own funds (and not cash provided by the acquiring corporation). Because of the strictness of the "solely in exchange for voting stock" requirement, a Type B reorganization is often less desirable than other types of tax-free reorganizations. To qualify as a Type B reorganization, an acquiring corporation does not need to acquire all of the stock at one time if all of the acquisitions are part of an integrated plan and the only consideration used for any of the acquisitions is voting stock. For example, this could be the case if the acquiring corporation acquired some target stock in an earlier stock-for-stock tender offer. If a liquidation of the target corporation is planned following a transaction structured as a Type B reorganization, the transaction generally is treated as a Type C reorganization and not a Type B reorganization (see Rev. Rul. 67-274 and Direct Type C Reorganization). After a Type B reorganization, the acquiring corporation can generally transfer the acquired stock to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-free reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively, if a drop down is planned, the transaction can be structured as a triangular Type B reorganization (see Triangular Type B Reorganization).
Tax Consequences of a Direct Type B Reorganization

If the requirements of a direct Type B reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock transfers. Target Corporation Stockholders The target corporation stockholders do not recognize taxable gain or loss on the exchange of their target stock for acquiring corporation voting stock (see IRC 354). The target corporation stockholders take a carryover basis in the acquiring corporation voting stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target Corporation The target corporation does not recognize gain or loss in the tax-free reorganization. In addition, the target corporation's basis in its assets remains unchanged. After the tax-free reorganization, the target corporation is 80% or more owned by the acquiring corporation.
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Acquiring Corporation The acquiring corporation generally does not recognize gain or loss in the tax-free reorganization (see IRC 1032). The acquiring corporation takes a carryover basis in the target corporation stock (generally the same basis that the target corporation stockholders had in the target corporation stock) (see IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Direct Type C Reorganization

In a direct Type C reorganization, the acquiring corporation acquires "substantially all" the assets of the target corporation in exchange for voting stock of the acquiring corporation and the target liquidates (see IRC 368(a)(1)(C)). In the liquidation, the target corporation distributes the acquiring corporation stock and other consideration received in the transaction (as well as any other target assets) to the target corporation stockholders. After the transaction, the target corporation stockholders who participated in the transaction become stockholders of the acquiring corporation. The COI requirement is built into the statute for a Type C reorganization (voting stock plus limited boot as permissible consideration), but the transaction must also satisfy the COBE and business purposes requirements. A Type C reorganization that fails to meet the necessary requirements is taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235)). A direct Type C reorganization is shown in the diagrams below:
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Substantially all the assets means assets representing at least 90% of the target corporation's net assets (assets less liabilities) and at least 70% of the target corporation's gross assets. This requirement prevents the target corporation from spinning-off or otherwise disposing of unwanted assets before the transaction. The only permissible consideration in a Type C reorganization is voting stock and a limited amount of boot. In many instances, voting preferred stock is treated as voting stock (generally if the holder of the voting preferred stock has the right to vote on the election of directors) (see Rev. Rul. 63234). Up to 20% of the consideration in a Type C reorganization can be boot (for example, cash and nonvoting stock). The acquiring corporation's assumption of target corporation's liabilities generally is not treated as boot. However, if actual boot (for example, cash or non-voting stock) is used in the transaction, the assumption of a liability will be treated as cash boot in the amount of the assumed liability for purposes of calculating the 20% of permissible boot. This rule prevents the use of actual boot if the acquiring corporation assumes liabilities that equal or exceed 20% of the consideration in the transaction. Prior ownership of stock of the target corporation by an acquiring corporation will not by itself prevent the transaction from qualifying as a Type C reorganization provided that the acquiring
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corporation did not purchase the target corporation stock in connection with the acquisition of the target's assets in the Type C reorganization (see Treas. Reg. 1.368-2(d)(4)). After a Type C reorganization, the acquiring corporation can generally transfer the acquired assets to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-free reorganization status (see IRC 368(a)(2)(C) and Treas. Reg. 1.368-2(k)(1)). Alternatively, if a drop down is planned, the transaction can be structured as a triangular Type C reorganization (see Triangular Type C Reorganization).
Tax Consequences of a Direct Type C Reorganization

If the requirements of a direct Type C reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock and asset transfers. Target Corporation Stockholders The target corporation stockholders do not recognize taxable gain or loss on the distribution of voting stock of the acquiring corporation on the liquidation of the target corporation (see IRC 354). However, the target corporation stockholders that receive boot in the liquidation are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock (generally redeemable preferred stock which does not participate in corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to a target corporation stockholder. The target corporation stockholder takes a carryover basis in the acquiring corporation stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target Corporation The target corporation generally does not recognize gain or loss in the tax-free reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist. Acquiring Corporation The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a carryover basis in the target corporation's assets (generally the same basis that the target corporation had in the assets) (see IRC 362 and 1032). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Acquisitive D Reorganization
For a transaction to qualify as an acquisitive Type D reorganization (see IRC 368(a)(1)(D)), the following requirements must be satisfied: The acquiring corporation acquires "substantially all" the assets of the target corporation.
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Immediately after the transfer of assets, the target corporation or its stockholders (or a combination of the two) has "control" of the acquiring corporation (see IRC 368(a)(1)(D)). The target corporation must liquidate and distribute the acquiring corporation stock and any other consideration received by the target corporation from the acquiring corporation (as well as the target's other properties (if any)) to the target corporation stockholders in a transaction that qualifies under IRC 354. The transaction must meet the COBE and business purposes requirements. A corporate group may engage in an acquisitive Type D reorganization to facilitate a corporate restructuring. An acquisitive Type D reorganization that fails to meet the necessary requirements is taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235)). An acquisitive Type D reorganization is shown in the diagrams below:
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In an acquisitive Type D reorganization, a special control test applies. Control means at least 50% of the total combined voting power of all classes of stock entitled to vote or at least 50% of the total number of shares of all other classes of stock. Although an acquisitive Type D reorganization does not specifically require the use of acquiring corporation stock as consideration, the "control" requirement effectively requires the use of acquiring corporation stock as consideration. For example, unless the target corporation or its stockholders owned significant amounts of acquiring stock before the transaction, the transaction will not qualify as an acquisitive Type D reorganization treatment unless the consideration includes substantial amounts of acquiring corporation stock. "Substantially all" has the same meaning as in a Type C reorganization (assets representing at least 90% of the target corporation's net assets and at least 70% of the target corporation's gross assets). Under a tiebreaker rule, a reorganization that qualifies as both a Type C and Type D is treated as a Type D reorganization (see IRC 368(a)(2)(A)). After an acquisitive Type D reorganization, the acquiring corporation can generally transfer the acquired assets to an 80% or more owned subsidiary (existing or newly formed) without jeopardizing tax-free reorganization status (see Rev. Rul. 2002-85).
Tax Consequences of an Acquisitive Type D Reorganization

If the requirements of an acquisitive Type D reorganization are satisfied, the parties generally defer current US federal income tax on gains on their stock and asset transfers. Target Corporation Stockholders The target corporation stockholders do not recognize taxable gain or loss on the distribution of stock of the acquiring corporation on the liquidation of the target corporation (see IRC 354). However, the target corporation stockholders that receive boot in the liquidation are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock (generally redeemable preferred stock which does not participate in corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to a target corporation stockholder. The target corporation stockholder takes a carryover basis in the acquiring corporation stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target Corporation The target corporation generally does not recognize gain or loss in the tax-free reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist. Acquiring Corporation The acquiring corporation does not recognize gain or loss in the tax-free reorganization and takes a
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carryover basis in the target corporation's assets (generally the same basis that target corporation had in the assets) (see IRC 362 and 1032). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition.
Triangular Reorganizations
Types A, B and C acquisitive reorganizations can often be structured as triangular tax-free reorganizations. Unlike a direct reorganization which involves two parties (the target corporation and the acquiring corporation), a triangular reorganization generally involves three parties: the target corporation on the seller side and a parent corporation and a subsidiary (typically whollyowned) on the buyer side. There are two types of triangular Type A reorganizations: a Type A forward subsidiary merger and a Type A reverse subsidiary merger.
Type A Forward Subsidiary Merger

In a forward subsidiary merger, the target corporation merges under state law into an existing or newly formed subsidiary in exchange for parent corporation stock (and any other consideration that is specified in the merger agreement). For corporate purposes, the target's assets and liabilities become assets and liabilities of the subsidiary (which remains wholly owned by the parent) and the target ceases to exist. A forward subsidiary merger qualifies as a tax-free reorganization (see IRC 368(a)(2)(D)) if the following requirements are satisfied: Type of subsidiary. The subsidiary must be 80% or more "controlled" by the parent corporation. This means that the parent corporation must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the subsidiary corporation. The subsidiary that is used in a forward subsidiary merger can be a disregarded entity for tax purposes (see Type A Forward Subsidiary Merger with a Disregarded Entity and Direct Type A Reorganization with a Disregarded Entity). Amount of assets. The subsidiary must acquire "substantially all" the assets of the target corporation in merger. Substantially all has the same meaning as in a Type C reorganization (assets representing at least 90% of the target corporation's net assets and at least 70% of the target corporation's gross assets). This requirement limits the target corporation's ability to spinoff or otherwise dispose of unwanted assets before the merger. Type of stock. The stock consideration in the merger is limited to parent corporation stock but there are generally not any restrictions on the type of parent stock (common or preferred and voting or non-voting) that can be used as consideration. The target corporation cannot receive any subsidiary stock in the transaction. However, it is permissible to use subsidiary debt
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securities in the transaction. Qualification as a direct Type A reorganization. The merger would have qualified as a direct Type A reorganization if the target corporation merged directly into the parent corporation (see Treas. Reg 1.368-2(b)(2)). This means that 40% or more of the merger consideration must be parent corporation stock (COI requirement) and the transaction must also meet the COBE and business purpose requirement. A Type A forward subsidiary merger that fails to meet the necessary requirements is taxed as an asset acquisition (see Practice Note, Mergers: Tax Overview (www.practicallaw.com/0-383-6747)). A Type A forward subsidiary merger is shown in the diagrams below:
In the transaction, the parent corporation can assume liabilities of the target corporation without jeopardizing tax-free reorganization status (see Treas. Reg 1.368-2(b)(2)). After a Type A forward subsidiary merger, the acquired assets and subsidiary stock can generally
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be transferred to or dropped into a sister or second-tier subsidiary (provided that the sister or subsidiary are 80% or more owned by the transferor) without jeopardizing tax-free reorganization status (see Rev. Rul. 2001-24 and Treas. Reg. 1.368-2(k)(1)). Tax Consequences of a Type A Forward Subsidiary Merger The tax consequences of a Type A forward subsidiary merger are as follows: Target corporation stockholders. The target corporation stockholders do not recognize taxable gain or loss on the exchange of their target stock for parent stock (see IRC 354). However, the target corporation stockholders that receive boot are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. Non-qualified preferred stock (generally redeemable preferred stock which does not participate in corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to a target corporation stockholder. The target corporation stockholder takes a carryover basis in the parent stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target corporation. The target corporation generally does not recognize gain or loss in the taxfree reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist. Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss in the tax-free reorganization and takes a carryover basis in the target corporation's assets (generally the same basis that target corporation had in the assets) (see Treas. Reg. 1.1032-2 and IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Parent corporation. The parent corporation does not recognize gain or loss in the tax-free reorganization (see Treas. Reg. 1.1032-2). Type A Forward Subsidiary Merger with a Disregarded Entity In certain cases, a forward subsidiary merger involving a disregarded entity can qualify as a Type A forward subsidiary merger. A disregarded entity is an entity with a single owner that is generally ignored for tax purposes even though it is a separate legal entity for state law purposes. For example, a single-member LLC is treated as a disregarded entity for tax purposes unless it elects to be taxed as corporation. The single owner of the disregarded entity is considered to own the assets (and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. For more information about disregarded entities, see Practice Note, Choice of Entity: Tax Issues (www.practicallaw.com/1-382-9949). A forward subsidiary merger of a target corporation into a disregarded entity may qualify as a Type
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A forward subsidiary merger. For this to be the case, there are four entities involved in the transaction rather than three because the disregarded entity is ignored for tax purposes. There is a target corporation on the seller side and a parent corporation, a subsidiary, and disregarded entity on the buyer side. For example, the merger of a target corporation into a disregarded entity owned by a subsidiary (which is in turn 80% or more owned by the parent corporation) may qualify as a Type A forward subsidiary merger. To qualify, the target stockholders must receive parent corporation stock and the target corporation must transfer substantially all of its assets to the disregarded entity (see Treas. Reg. 1.368-2(b)(1)(iii), ex. 4). For a direct Type A merger with a disregarded entity, see Direct Type A Reorganization with a Disregarded Entity.
Type A Reverse Subsidiary Merger

In a reverse subsidiary merger, a subsidiary of the parent corporation (usually newly formed) merges under state law into the target corporation in exchange for parent corporation stock (and any other consideration that is specified in the merger agreement). For corporate purposes, the subsidiary's assets and liabilities (usually a newly formed subsidiary with little or no assets or liabilities) become the assets and liabilities of the target, the target is now wholly owned by parent and the subsidiary ceases to exist. A reverse subsidiary merger qualifies as a tax-free reorganization (see IRC 368(a)(2)(E)) if the following requirements are satisfied: Type of subsidiary. The subsidiary must be 80% or more "controlled" by the parent corporation. This means that the parent corporation must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the subsidiary corporation. Control and voting stock. The target corporation stockholders must exchange an amount of stock representing "control" of target solely in exchange for parent voting stock. In many instances, voting preferred stock is treated as voting stock (generally if the holder of the voting preferred stock has the right to vote on the election of directors). Other consideration (including subsidiary stock) may be used to acquire the remaining target corporation stock. Control has the same meaning as in a Type B reorganization (at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock).
Amount of assets. After the merger, the target corporation must continue to own "substantially all" of the assets of the target corporation and of the subsidiary of the parent corporation (usually a newly formed subsidiary is used with little or no assets). Substantially all has the same meaning as in a Type C reorganization (assets representing at least 90% of the target corporation's net assets and at least 70% of the target corporation's gross assets). Judicial requirements. The reverse subsidiary merger must also satisfy the COBE and business purpose requirements. The COI requirement is built into the statute for a Type A
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reverse subsidiary merger (voting stock plus a limited amount of boot as permissible consideration). A Type A reverse subsidiary merger that fails to meet the necessary requirements is taxed as an stock acquisition. For more information, see Practice Note, Mergers: Tax Overview (www.practicallaw.com/0-383-6747). A Type A reverse subsidiary merger is shown in the diagrams below:
In the transaction, the parent corporation can assume liabilities of the target corporation without jeopardizing tax-free reorganization status (see Treas. Reg 1.368-2(j)(4))). In addition, drop downs (either of acquired target stock or acquired assets) to an 80% or more owned subsidiary after a Type A reverse subsidiary merger do not jeopardize tax-free reorganization status (see Treas. Reg. 1.368-2(k)(1)). A significant difference between a Type A reverse subsidiary merger and a direct Type A reorganization or Type A forward subsidiary merger is that the stock consideration used in a Type A reverse subsidiary merger must be voting stock. In a direct Type A reorganization or Type A
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forward subsidiary merger, non-voting stock is permissible. Because the Type A reverse subsidiary merger rules are more restrictive than the direct Type A reorganization and Type A forward subsidiary merger rules, a Type A reverse subsidiary merger is typically used only when it is important for corporate purposes that the target corporation survive (for example, the target corporation's assets are difficult to transfer or are non-transferable). Tax Consequences of a Type A Reverse Subsidiary Merger The tax consequences of a Type A forward subsidiary merger are as follows: Target corporation stockholders. The target corporation stockholders do not recognize taxable gain or loss on the exchange of their target stock for parent voting stock (see IRC 354). However, the target corporation stockholders that receive boot are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. The target corporation stockholder takes a carryover basis in the parent stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target corporation. The target corporation generally does not recognize gain or loss in the reorganization. The target corporation's basis in its assets remains unchanged (see IRC 361) and the target corporation takes a carryover basis in the subsidiary corporation's assets (usually a newly formed subsidiary with little or no assets). Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss in the tax-free reorganization. After the tax-free reorganization, the subsidiary ceases to exist. Parent corporation. The parent corporation does not recognize gain or loss in the tax-free reorganization.
Triangular Type B Reorganization

In a triangular Type B reorganization, a subsidiary of the parent corporation acquires the stock of the target corporation solely in exchange for voting stock of the parent corporation and, immediately after the transaction, the subsidiary corporation has "control" of the target corporation (see IRC 368(a)(1)(B)). Control is the same 80% control test that is used in a direct Type B reorganization (see Direct Type B Reorganization). The COI requirement is built into the statute for a triangular Type B reorganization (parent voting stock as the only permissible consideration) but the transaction must also meet the COBE and business purposes requirements. A triangular Type B reorganization that fails to meet the necessary requirements is taxed as a stock acquisition (see Practice Note, Stock Acquisitions: Tax Overview (www.practicallaw.com/9-383-6719)). A triangular Type B reorganization is shown in the diagrams below:
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Like the Type A triangular reorganizations, the subsidiary used in the transaction must be 80% or more "controlled" by the parent corporation. After the transaction, the target corporation is 80% or more owned by the subsidiary corporation and the target corporation stockholders who participated in the transaction become stockholders of the parent corporation. Because the target corporation continues to exist, stockholders that opted not to participate in the reorganization can continue to own target corporation stock as minority stockholders if that is permitted under state law. The stock consideration in the transaction is limited to voting stock (common or preferred) of either the parent corporation or the subsidiary corporation. A mixture of parent and subsidiary stock is not permitted. If the subsidiary used its own stock, the transaction would be a direct Type B reorganization (see Direct Type B Reorganization). Drop downs of acquired target corporation stock to an 80% or more owned subsidiary after a triangular Type B reorganization do not jeopardize tax-free reorganization status (see Treas. Reg. 1.368-2(k)(1)).
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Tax Consequences of a Triangular Type B Reorganization The tax consequences of a triangular Type B reorganization are as follows: Target corporation stockholders. The target corporation stockholders do not recognize taxable gain or loss on the exchange of their target stock for parent voting stock (see IRC 354). The target corporation stockholders take a carryover basis in the parent corporation voting stock (generally the same basis that the stockholder had in its target corporation stock) (see IRC 358). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Target corporation. The target corporation does not recognize gain or loss in the tax-free reorganization. In addition, the target corporation's basis in its assets remains unchanged. After the tax-free reorganization, the target corporation is 80% or more owned by the subsidiary corporation. Subsidiary corporation. The subsidiary corporation generally does not recognize gain or loss in the tax-free reorganization (see IRC 1032). The subsidiary corporation takes a carryover basis in the target corporation stock (generally the same basis that the target corporation stockholders had in the target corporation stock) (see IRC 362). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Parent corporation. The parent corporation does not recognize gain or loss in the tax-free reorganization (see Treas. Reg. 1.1032-2).
Triangular Type C Reorganization

In a triangular Type C reorganization, a subsidiary of parent corporation acquires "substantially all" the assets of the target corporation in exchange for voting stock of the parent corporation and the target corporation liquidates (see IRC 368(a)(1)(C)). In the liquidation, the target corporation distributes the parent corporation stock and other consideration received in the transaction (as well as any other target assets) to the target corporation stockholders. After the transaction, the target corporation stockholders who participated in the transaction become stockholders of the parent corporation. The COI requirement is built into the statute for a Type C reorganization (voting stock plus limited boot as permissible consideration) but the transaction must also meet the COBE and business purposes requirements. A triangular Type C reorganization that fails to meet the necessary requirements is taxed as an asset acquisition (see Practice Note, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235)). A triangular Type C reorganization is shown in the diagrams below:
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Like the Type A triangular reorganizations, the subsidiary used in the transaction must be 80% or more "controlled" by the parent corporation. Like a triangular Type B reorganization, the stock consideration in the transaction is limited to voting stock (common or preferred) of either the parent corporation or the subsidiary corporation. A mixture of parent and subsidiary stock is not permitted. If the subsidiary used its own stock, the transaction would be a direct Type C reorganization (see Direct Type C Reorganization). Like a direct Type C reorganization, up to 20% of the consideration can be boot (for example, cash and nonvoting stock). If any actual boot is paid, the assumption of a liability will also be treated as cash boot for purposes of calculating the 20% of permissible boot (see Direct Type C Reorganization). Drop downs of acquired assets to an 80% or more owned subsidiary after a triangular Type C reorganization do not jeopardize tax-free reorganization status (see Treas. Reg. 1.368-2(k)(1)). Tax Consequences of a Triangular Type C Reorganization The tax consequences of a triangular Type C reorganization are as follows: Target corporation stockholders. The target corporation stockholders do not recognize
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taxable gain or loss on the distribution of voting stock of the parent corporation on the liquidation of the target corporation (see IRC 354). However, the target corporation stockholders that receive boot (consideration other than parent voting stock) in the liquidation are taxed on the receipt of that boot as either capital gain or a dividend (see IRC 356). The taxable amount is the lesser of the amount of boot or the total gain on the transaction. Nonqualified preferred stock (generally redeemable preferred stock which does not participate in corporate growth to any significant extent) generally is considered boot and, therefore, is taxable to a target corporation stockholder. Target corporation. The target corporation generally does not recognize gain or loss in the taxfree reorganization (see IRC 361). After the tax-free reorganization, the target ceases to exist. Subsidiary corporation. The subsidiary corporation does not recognize gain or loss in the taxfree reorganization and takes a carryover basis in the target corporation's assets (generally the same basis that the target corporation had in the assets) (see IRC 362 and 1032). The receipt of a carryover basis preserves the unrecognized gain for later recognition in a taxable sale or other disposition. Parent corporation. The parent corporation does not recognize gain or loss in the tax-free reorganization (see Treas. Reg. 1.1032-2).
Carryover of NOLs after a Tax-Free Reorganization

Before a tax-free reorganization, the target corporation may have valuable tax attributes that can be used to offset its taxable income and the acquiring corporation may want to obtain access to those pre-reorganization tax attributes. One example of a valuable tax attribute is net operating losses (www.practicallaw.com/8-382-3642) (NOLs). A taxpayer has a NOL when its allowable deductions exceed its gross income in a specific taxable year (see IRC 172). In a transaction that is structured as a tax-free acquisitive reorganization, the acquiring corporation obtains access (directly or indirectly) to the pre-reorganization tax attributes (such as NOLs) of the target corporation, subject to several limitations. The most significant limitations on the use of the target corporation's tax attributes after a tax-free reorganization are IRC 269 and 382 (see Limitations of the Use of NOLs After a Tax-Free Reorganization). The tax attributes carryover regardless of whether the tax-free reorganization is structured as a stock or asset transfer for tax purposes. By contrast, in a taxable asset acquisition, the target corporation's NOLs do not carryover to the acquiring corporation (see Practice Notes, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235) and Mergers: Tax Overview (www.practicallaw.com/0-383-6747)). NOLs of a target corporation in tax-free reorganizations are treated as follows: Direct asset transfers. In direct Types A, C and acquisitive D reorganizations, the acquiring
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corporation inherits the target corporation's NOLs (see IRC 381), subject to the limitations in IRC 269 and 382. Indirect asset transfers. In Type A forward subsidiary mergers and triangular Type C reorganizations, the subsidiary corporation inherits the target corporation's NOLs (see IRC 381), subject to the limitations in IRC 269 and 382. Stock transfers. In a direct and triangular Type B reorganization as well as in Type A reverse subsidiary mergers, the target corporation's NOLs remain with the target and can be used by the target after the tax-free reorganization, subject to the limitations in IRC 269 and 382.
Limitations of the Use of NOLs After a Tax-Free Reorganization

Under IRC 269, the target corporation's tax attributes do not carryover if the principal purpose of the reorganization was to avoid tax by acquiring the tax attributes (for example, NOLs). IRC 382 generally limits the post-acquisition use of pre-reorganization NOLs (and certain built-in losses) of the target corporation after certain ownership changes. A tax-free acquisitive reorganization generally triggers an IRC 382 ownership change if the target corporation stockholders own less than 50% of the acquiring corporation's stock immediately after the tax-free reorganization (see IRC 382(g)). After a IRC 382 ownership change, the use of pre-reorganization NOLs (and certain built-in losses) is limited annually to an amount equal to the value of the target corporation's stock at the time of the reorganization multiplied by a statutory interest rate (see IRC 382(b)(1)).
Double Dummy Merger: Tax-Free Transaction but not Tax-Free Reorganization

The COI requirement for tax-free reorganizations requires that 40% or more of the consideration be stock of the acquiring corporation (or its affiliate). In some cases, the parties may want to use less stock consideration but still desire tax free treatment for the stockholders receiving stock consideration. A "double dummy" merger can be used to avoid the COI requirement because it is a tax-free transaction under IRC 351 and therefore not subject to the COI requirement. Like a tax-free reorganization, a double dummy merger provides tax-free treatment on the stock portion of the transaction (however, the cash/non-stock portion of the deal is taxable). It is used most frequently in a merger of equals. A double dummy merger is a transaction using double reverse subsidiary mergers with a new permanent holding corporation at the top. To facilitate the double dummy merger, three new companies are formed:
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New corporation (which will be the new holding company after the mergers). Subsidiary 1 (which will be merged into the target company). Subsidiary 2 (which will be merged into the acquiring company). A double dummy merger is shown in the diagrams below:
After the double dummy merger, the new holding corporation must be maintained permanently for the transaction to qualify as tax free under IRC 351. In addition, the former stockholders of the target and acquiring companies must "control" the new holding corporation. Like many of the tax-free reorganizations, control means at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock.
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The tax advantages of the double dummy structure over a tax-free reorganization are: No COI requirement. No "substantially all" the assets requirement. No requirement that the new holding corporation "control" the target or the acquiring company. Target and acquiring companies do not need to be corporations. For corporate reasons, the double dummy merger is not used frequently despite the tax advantages. For example, the parties often do not want a new corporate structure with a permanent holding company at the top. In addition, the double reverse mergers may double the amount of necessary third party consents.
Resource information
Resource ID: 0-386-4212 Products: PLC Corporate and Securities, PLC US Law Department This resource is maintained, meaning that we monitor developments on a regular basis and update it as soon as possible.
Resource history
Resource created We will track here amendments to this resource that reflect changes in law and practice.
Related content
Topics Asset Acquisitions (http://uscorporate.practicallaw.com/topic7-380-7421) Private Mergers (http://uscorporate.practicallaw.com/topic1-380-7424) Private Stock Acquisitions (http://uscorporate.practicallaw.com/topic8-380-7425) Public Mergers and Acquisitions (http://uscorporate.practicallaw.com/topic6-380-7426) Tax (http://uscorporate.practicallaw.com/topic1-500-3050) Practice Note: Overview Asset Acquisitions: Overview (http://uscorporate.practicallaw.com/topic6-380-7695) Asset Acquisitions: Tax Overview (http://uscorporate.practicallaw.com/topic6-383-6235)
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Mergers: Tax Overview (http://uscorporate.practicallaw.com/topic0-383-6747) Private Mergers: Overview (http://uscorporate.practicallaw.com/topic0-380-9145) Public Mergers: Overview (http://uscorporate.practicallaw.com/topic4-382-2164) Stock Acquisitions: Overview (http://uscorporate.practicallaw.com/topic4-380-7696) Stock Acquisitions: Tax Overview (http://uscorporate.practicallaw.com/topic9-383-6719) Practice Notes Choice of Entity: Tax Issues (http://uscorporate.practicallaw.com/topic1-382-9949) Private Acquisition Structures (http://uscorporate.practicallaw.com/topic6-380-9171) What's Market: Tax-free Transactions (http://uscorporate.practicallaw.com/topic5-386-1032) Article: know-how US corporate taxation: an introduction (http://uscorporate.practicallaw.com/topic6-384-0223)
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PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

General Categories of Tax-Free Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

General Requirements to Qualify as a Tax-Free Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Judicial Requirements for All Tax-Free Reorganizations

Direct Type A Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Tax Consequences of a Direct Type A Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Direct Type A Reorganization with a Disregarded Entity

Direct Type B Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Tax Consequences of a Direct Type B Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Direct Type C Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Tax Consequences of a Direct Type C Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Tax Consequences of an Acquisitive Type D Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Type A Forward Subsidiary Merger

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Type A Reverse Subsidiary Merger

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Triangular Type B Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Triangular Type C Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Carryover of NOLs after a Tax-Free Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

Limitations of the Use of NOLs After a Tax-Free Reorganization

Double Dummy Merger: Tax-Free Transaction but not Tax-Free Reorganization

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

PLC - Tax-Free Reorganizations: Acquisitive Reorganizations

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